July 1, 2019
Years ago, Benjamin Graham — the father of value investing and mentor to Warren Buffett — noted how capricious the markets can be when he observed that “Mr. Market” suffers from emotional problems bordering on a split personality. He is overly exuberant at times and inexplicably depressed at others. And while influenced by the health of the economy, Mr. Market seems oddly unmoored from it on a frequent basis. While this observation was made more than 70 years ago, this behavior continues to endure today.
On the economic front, the current expansion is set to become the longest on record since the 1860’s. On multiple fronts the economy remains in fine fettle: Small business optimism, the economy’s lodestar, remains exceptionally strong — nearly two-thirds of small business owners recently made new investments in their businesses, the highest level since February 2018;1 employment continues to grow; and consumers continue to consume.
While the economy continues to canter along, a number of recent developments have pointed to a slower pace of activity. The precipitous drop in the Composite Purchasing Managers’ Index from the mid-50s to 50.6 in May was a jarring development that suggests all might not be well (Exhibit A). A similar development recently occurred with the Conference Board’s Index of Consumer Confidence. Combine this with a flat-to-inverting yield curve and a weak employment report and conditions were set to induce a spasm of investor anxiety. This is exactly what has happened to the equity market. Before rebounding, the S&P 500 Index fell roughly 7% from May into June. Yet against the market angst, GDP trackers continued to show growth in the economy. This dichotomy of investor fear against the backdrop of continued, albeit slowing, growth induced Mr. Market’s dyspepsia in the waning days of the second quarter.
Connecting the Disconnect
Markets are ultimately pulled along by the trajectory of the economy and the profits generated within it. However, the gears that link the former to the latter occasionally slip as the factors that drive economic and profit growth fall into conflict or are misread. In short, a fall in stock prices does not reliably foretell a recession. Similarly, a waning of economic activity does not always prefigure a drop in profits that necessitates a revaluation of stock prices.
To level set our expectations against the current backdrop, 2019 will likely be a very good year for the stock market as the S&P 500 index will probably finish the year somewhere between 2,750 and 2,800. This would represent a calendar year gain of roughly 12% — a solid year by any standard. The bad news, however, is that the S&P 500 is trading above those levels. Despite our ongoing confidence in the health of the underlying economy, we reckon this could be a tough summer for the markets. While equities bounced back from their recent swoon, this rebound may struggle as investors price in slower growth and earnings, as well as the complexities of the multi-front trade conflict.
The Split Calendar
There is a pithy maxim that investors should “sell in May and go away” — at least until November. There is some truth to this adage: The S&P 500 typically has struggled from May through October while accelerating from November through April. Indeed, since 1945, more than 80% of the annual gains for the stock market have been generated in the six months from November through April.
As a rule investing by motto may not yield the best results, especially one that calls for investors to exit long-held positions in securities that could trigger hefty tax bills. Yet, these old nostrums do hold kernels of insight and, given the current state of play, rebalancing a portfolio back to its tactical weights is wise as investors are acting from positions of strength.
Our cautious outlook stems from a belief that equity investors have yet to fully price in the slower growth brought about by the global trade war (the trade conflict with China has the potential to shave nearly half a percentage point of growth from US GDP this year). Equally important is the fact that equities have enjoyed more than a year’s worth of gains in the first six months of 2019. Even factoring in May’s slide, the Russell 2000 small cap index has gained 17% this year while the Russell 1000 large- and mid-cap index is up nearly 18.8% (Exhibit B).
As noted above, we have been generally recommending rebalancing portfolios by selling investments that have gone up disproportionately and rebuilding cash levels to take advantage of opportunities that may present themselves later this year. Also, the summer months may be an opportune time to comb through portfolios to identify and sell marginal holdings that have questionable upside.
The Great Divide on Interest Rates
To say that the markets are forecasting the possibility of an interest rate cut in July is an understatement. According to recent readings in Fed Funds futures contracts, Wall Street is predicting that the Federal Reserve will trim short-term interest rates in late July (Exhibit C). The only question is by how much; the futures market is signaling a 75% probability of a 0.25 percentage point cut. Investors want a rate cut and a rate cut they will most likely get. After all, central banking in the 21st century follows, not leads, opinion setters. Have fortunes reversed so significantly that a rate cut is needed? From our perch, the answer is, no.
Indeed, we agree the economy is slowing, as is corporate profit growth. To wit, the consensus forecast for S&P 500 profit growth started the year at roughly 9% and it is currently at 3%. This may be an overly pessimistic assessment of the slowing of profit growth; however, the size of the drop is notable when, at the same time, prices paid for that shrinking profit growth are up roughly 17%. While Mr. Market is certain that rates need to be cut, we are less so. If the economy is the fragile flower the futures market suggest, should stocks be trading at roughly 19 times trailing earnings and 17x forward profits? The habit of investors seeking protection via interest rate relief from central bankers is worrisome. Cheap money is the narcotic equivalent to the investor class. The longer one is exposed, the harder it is to wean. After 20 years of the Fed Put, one cannot help but wonder if markets can successfully operate with a market-determined price of money.2
And Now Something Completely Different: A Most Unconventional Idea
One of the most fascinating events unfolding in the markets is the process the United Kingdom is enduring as it separates itself from the European Union economic bloc. After 43 years as a member of this bloc, Britain voted to leave via a referendum in June 2016. Despite the legions of pre-vote warnings of impending doom if the British decided to leave, the horsemen of the apocalypse failed to appear. Indeed, rather than slip into forecasted economic atavism, Britain’s economy has continued to grow, and with an employment rise pulling prices along with it. Moreover, UK equities have failed to follow the doomsday script by not falling apart.
What is remarkable about all of this is the fact that three years after the vote a deal remains elusive. While a deal was struck, it was one no one wanted. As it is with such things, when the government cannot deliver change, the government itself is changed. As of this writing, it appears that Boris Johnson, the former Foreign Secretary and Original Brexiteer, will have a go as the country’s Prime Minister. Johnson has pledged a binary outcome: a new deal or a no-deal exit on October 31 — the date beyond which the European Union will be without the UK.
Predictably, the dire warnings from the commentariat are spooling up again. If Britain leaves the economic union without a plan, chaos will undoubtedly ensue, but things will be sorted. Lost in the noise is the realization that the UK’s time in the EU has been a fraction of its life as a developed country. Its major exports— language, law, and culture — will remain as valuable outside the Union as it was inside. With courage it could fashion itself as the Singapore of the North Atlantic or it could turn to the Commonwealth and fashion a trading zone that shares a myriad of historical links to the island nation. Without a doubt, the British are not without options as they find their way forward.
With this in mind, we are tempted to look anew at UK equities. This market has understandably lagged other markets; however, earnings growth appears set to return in force and investors have yet to account for it. Perhaps they have succumbed to doubt or settled into a “show me” mood. We are inclined to look favorably on the opportunity.
Continuing to focus on Europe, this economic bloc may offer a better opportunity for investors than conventional wisdom holds. First, the Trump administration is already waging a trade war on two major fronts — with China and, separately, with our North American neighbors. This might result in good news for Europe this year, as it could postpone any new trade hostilities directed toward the European Union.
Second, European equities are as popular as a dark suit on a sunny day at the moment. However, it remains an interesting region in which to consider investing. Blue Chip European companies are global in nature, though they are on average smaller than their US counterparts. They are also cheaper: The price/earnings ratio for European stocks is 13.9 — nearly 5% lower than their 25-year average P/E. By contrast, the P/E for US large-cap stocks is more than 4% higher than the historic average (Exhibit D). Moreover, European equities tend to enjoy higher dividend yields than US companies.
If there is a silver lining in Europe to the Brexit machinations, it will reside in the opportunity for reform of the project. Cited as undemocratic, bureaucratic, and heavily regulated, the ruling class in Brussels could amend their ways to improve relations inside the bloc.
Conservative and Short
The big debate is whether the flattening yield curve is a sign of an impending recession, as many market watchers believe. Historically, when shorter-term Treasurys are yielding as much or more than their longer-term counterparts, it is an indicator of an economic downturn lurking.
While unsettling, a recession is far from imminent. Without a doubt, part of the reason for the flat curve may stem from fears of a global slowdown; however, the US bond market must be put into global context. Simply put, would rates have fallen the way they have this year if Japanese and European bonds were not sporting negative interest rates? Considering that there is half a trillion dollars’ worth of corporate paper in Europe and $11 trillion in overall debt on the Continent sporting negative rates, it is understandable why demand for Treasurys that are yielding a number greater than zero remains high.
That said, the reality is that the yield curve is flat. As a result, the game gets very simple when it comes to fixed income. We recommend investors consider placing new money at the short-end of the curve — maturities of two to three years — since one does not have to accept duration risk to earn a modicum of yield.
So Far So Good, But Not Good Enough
Market returns have been solid during the first half of the year. Indeed, success was a function of simply being invested. That is set to change as uncertainty on trade policy and rising conflict in the Middle East recaptures headlines. Moreover, as growth slows and profits reset, investors will have to once again contemplate their place in the business and market cycle. Whether rebalancing to tactical weights or banking gains on large positions, portfolio grooming is the order of the day. The benefit of acting now is that it is done from a position of strength, which is always a good position.
1 NFIB Small Business Optimism Index, Bloomberg
2 The ‘Fed Put’ is short hand for the belief that the Central Bank will attempt to ameliorate market declines by providing liquidity through interest rate cuts.
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.